Аpplication of discounting to Russian companies

Even though discounting has been rarely used by Russian accountants, it seems to be a very important point. Discounting of future flows might have a strong influence on the balance sheet value of almost every item and can change a company’s financial result significantly. Even when you realize the purpose of discounting, the importance of the estimation of the rate which you will use might be understated. This might be even more urgent when talking about emerging markets and Russian economy in particular.

First, let us refer to the meaning of the discount rate given by Shannon Pratt in his book “Valuing a business”:

The discount rate is the expected rate of return that would be required to attract capital to the investment, which takes into account the rate of return available from other investments of comparable risk.

Thus, discount rates normally should include the estimation of all the risks that a diversified investor might face. The idea of discounting is to reflect the fact that the real value of future cash flows differs from their nominal value significantly. One of the reasons why this happens is inflation. When talking about nominal rates, the expected level of inflation must be involved. It is obvious that using a discount rate for a country which is in the situation of its inflation rate being close to zero is absolutely inapplicable for Russian economy where for the year of 2015 inflation is on the level of 13%.

Besides the level of inflation, the reason why money today is worth less than it will be tomorrow is in other alternative investment opportunities. So, discount rate represents an opportunity cost for an investor.

Fair value accounting which is meant to reflect the time value of money definitely requires a bigger effort which brings a company’s administrative costs go up. However, it makes financial statements of a company way more transparent which improves its investment attractiveness.

According to IFRS, Financial assets and liabilities recognition should be made using their fair value. The goal of this article is to come up with the idea of how to assess this fair value based on the data being available.

In case there is an active market for a certain asset then the fair vale must be estimated based on the information from this market. In case there is no active market for a certain item, valuation techniques must be used. This is mostly relevant for long-term assets and liabilities as discounting those with a short term maturity does not bring significant differences in their value.

One of the examples of such items which should be evaluated are loans being provided or borrowed which are settled on the conditions different from the market ones. To assess such items fairly, there must be adjustments in financial statements made as if these items would have been made in an arm’s length transaction.

There are requirements in IAS 39 regarding evaluating financial assets and liabilities which state that valuation techniques must use arm’s length transactions happened recently on the open market, if available, and should refer to the current fair value of another instrument that is similar in various points. When using a valuation technique, widely used ones on the market should be examined and taken as a basis, if there are any. The chosen technique should use common market assumption to the biggest extent and specific company’s ones should be minimized.

In order to be appropriate for valuation, a discount rate should reflect current market conditions and the level of the rates existing for similar transactions, instruments. Criteria being taken into account includes the period to maturity, collateral, currency in which a loan is provided, etc.

Very often it can be hard to find a very similar financing tool, so we come up with the necessity to estimate the rate ourselves.

Firstly, we have to analyze the existing loans taken in the current year and if there are any – adjust their interest rates to get a necessary one. If there is no such data available, it might be possible to examine publicly traded bonds and use their yield to maturity (YTM).

It is also possible to find bonds of companies with a similar credit rating and estimate our rate. But what if there is no credit rating provided for our company? In this case we would offer to apply for information to Aswath Damodaran’s database where he estimates a respective credit rating based on the interest coverage ratio.

The interest coverage ratio measures the capacity of the firm to meet interest payments from pre-debt, pre-tax earnings.

EBIT

Interest coverage ratio =----------------

Interest expenses

The higher the interest coverage ratio, the more secure is the firm's capacity to make interest payments from earning.

Based on the figure of this ratio and Damodaran’s database we can find out a credit default spread and use it in order to estimate the discount rate. Large cap companies tend to be less risky, so, for a lower coverage ratio related to small- and mid-caps they get a higher rating. For example, in order to get AAA, large cap need to have an interest coverage ratio above 8,5, whereas for a smaller market cap the lower limit is 12,5. The spread for such companies is supposed to be about 0,75%.

Another option available for businesses performing in Russia is to use a banks’ statistics bulletin of the Central Bank. There we might find information which is segregated by currencies, terms to maturity, etc. However, it should be used only as an average basis for further adjustments.

Terms to maturity cause differences in the level of risk. This can be reflected by providing a yield curve which is normally upward sloping. Thus, the longer the term to maturity, the higher the level of risk for a specific instrument. In case we did not manage to find any comparable with the same term to maturity, we can adjust the interest rate of the one that was found using the comparable rate and adjust it for the difference in benchmark yields with the following formula:

(1+i b,^ench'^mark'}

^ Т    ^{(1 + i} t ) * (i+j^enchmark}

-1,

Where i_T - interest rate we need to find for a certain maturity; [ benchmark – interest rate of the benchmark security with the same maturity as our comparable; i T ^enchmark - interest rate of the benchmark with the necessary maturity. Here for the benchmark we can take, for example, Russian 10-Y government bonds yield.

Another case of adjustment is when we have a simple rate and need to make an effective compounded annual one out of it. In order to do this we should use the following formula:

ief = (1 + is * ^d/t - 1,

where i_s - a simple interest rate; t - number of days between two dates of paying interest; d - days in a year; i_e f - effective compounded rate.

In case there is a bong nominated in another currency, its yield will also differ. So, again adjustment is needed. In this case we offer to use interest parity condition with assumes that interest rates should be equal one to another being adjusted for expected currency depreciation or appreciation. For example, we need to estimate cost of debt nominated in Russian rubles, and we have USD nominated cost of debt. Then we should follow the equation:

p e           f^act

^ RUR/USD ^ R UR/USD

^[ rur = ^[ usd ⁺       те           ,

^RUR/USD where iUSD- interest rate in USD terms; iRUR - interest rate in ruble terms; ^rUr/USD - expected ruble/dollar exchange rate; E^a^/usD - actual exchange rate.

To sum up, in this article we have studied the option of applying discounting for Russian companies, in particular, discount rate estimation. The main issue with discount rates occurs when a company has no public debt and is not traded. So, the main steps we offer are the following:

• 1.    Check if a company has public bonds. If yes – use their YTM. If no, the next step should be taken.

• 2.    Find bonds of companies’ with a similar credit rating (use Damodaran’s database) and a similar maturity, currency and other terms. Use their YTM. If terms are different – take the next step.

• 3.    Find bonds with different terms and adjust them. Ways to adjust different terms are described in the main body of the article.

• 4.    Apply the rate obtained for future flows discounting.